C—IRA Distribution Planning
Funds cannot be kept in an IRA indefinitely. Eventually they must be distributed. Effective distribution planning requires a careful consideration of both tax and nontax issues. The first and most important consideration should be the owner's need for income. If funds are required before age 59½, the early distribution penalty tax must be avoided. If funds are left to accumulate after age 72, the 50 percent excise tax on undistributed minimum required distributions must be avoided. And finally, selection of beneficiaries not only determines those individuals who will inherit the IRA, but how and when the IRA will be subject to income taxation.
Early Distribution Penalty Tax
Distributions prior to the owner's age 59½ are subject to an additional 10 percent early distribution penalty tax, unless an exception applies. With a SIMPLE IRA, early distributions within two years of beginning participation are subject to a 25 percent penalty tax. Beneficiaries of inherited IRAs are not subject to this tax.
Required Minimum Distributions
Distributions that are less than the required minimum are subject to a 50 percent excise tax (i.e., it is levied on any amount not distributed as required). The amount and timing of these distributions will vary, and is dependent upon a number of factors, including the attained age of the owner, when the owner dies, the existence of a surviving spouse or designated beneficiaries, and the ages of these individuals. Roth IRA owners are generally not subject to these distribution requirements during their lifetimes (and are treated as dying before their RBD, see below).
Owner during lifetime. The owner of a traditional IRA must start receiving distributions by April 1 of the year following the owner's attaining age 73 (increasing to age 75 in 2033). This date is referred to as the required beginning date (RBD). Although this first distribution can be delayed, distributions for the second and future years must be made by December 31 (e.g., two distributions would have to be made in a single year if the first distribution was not made until April 1). If the IRA owner dies after reaching age 73 (or age 75 effective 2033), but before April 1 of the next year, no distribution is required (i.e., death occurred before the RBD).
The amount of the required minimum distribution (RMD) is calculated by dividing the IRA account balance at the end of the previous year by the life expectancy of the IRA owner and another person. This is also referred to as the applicable distribution period, or the RMD factor. For example, assume that an IRA owner is age 75 and has an account balance of $100,000. The RMD uniform lifetime table provides an RMD factor of 24.6. The required minimum distribution is $4,065 (100,000 ÷ 24.6 = 4065). This table is used when the owner is alive, and there is no designated beneficiary or the designated beneficiary is either: (1) a spouse not more than 10 years younger than the owner; or (2) a nonspouse beneficiary of any age. Under the incidental benefit rule, this table treats a nonspouse beneficiary as no more than 10 years younger than the IRA owner, thereby assuring that distributions are primarily for the benefit of the IRA owner.
When the owner is alive, and a spouse more than 10 years younger than the owner is the sole beneficiary, then the RMD joint and last survivor table can be used. Use of this table is particularly helpful if the spouse is substantially younger than the IRA owner (i.e., a longer joint life expectancy reduces the amount of the annual required minimum distribution). For example, assume that an IRA owner age 75 is married to a spouse age 45, and the account balance is $100,000. The RMD factor from this table is 39.2, and the required minimum distribution is $2,551 (100,000 ÷ 39.2 = 2,551).
Surviving spouse as beneficiary. A surviving spouse who is the sole primary beneficiary of
the deceased's IRA can either:
1. Elect to be designated as the account owner of the IRA (or use a "spousal rollover" to transfer assets to the spouse's traditional IRA). This allows for using the surviving spouse's age in determining required minimum distributions, and for the naming of new designated beneficiaries (i.e., the so-called "stretch IRA." However, if withdrawn by a surviving spouse under age 59½, these funds may be subject to the 10 percent early distribution penalty tax (a spouse who remains a beneficiary is not subject to this tax), or
2. Remain a beneficiary of the IRA, with the following results:
a. Distributions must generally be taken over the surviving spouse's lifetime (using the single life expectancy of the spouse). The first distribution must be made by the end of the year following the owner's death.
b. If the IRA owner dies on or after the RBD, the life expectancy of the owner can be used for any year if it is greater than the spouse's life expectancy. Nonspouse as beneficiary. Distributions to a designated beneficiary are determined by whether the IRA owner dies before or after the required beginning date (RBD):
1. If the owner dies before the RBD, distributions must be made by year 10, but there is no
requirement to take a distribution each year until year 10.
2. If the owner dies on or after the RBD, distributions must be made annually based on at least the life expectancy of the beneficiary, with the full account balance required to be distributed by the end of year 10 of receiving the inheritance.
No designated beneficiary.
1. If the owner dies before the RBD, distributions must be made under the five-year rule in which the full account balance must be distributed by the end of year 5 of receiving the inheritance.
2. If the owner dies on or after the RBD, distributions continue to made based upon the life expectancy of the deceased owner under the RMD single life table using the owner's age as of his or her birthday in the year of death, reduced by one for each year after the year of death.
Trust as beneficiary. A trust cannot technically be a designated beneficiary for RMD purposes, but the oldest beneficiary of a trust will be treated as the designated beneficiary if the trust meets certain specific requirements. This is commonly known as a "see-through" trust . If the trust fails to meet these requirements, then distributions must be made under the five-year rule. Before making a trust the beneficiary of an IRA, the advice of qualified counsel should be sought.
Designated beneficiary. This is the individual (or certain trusts) who is designated to receive the IRA proceeds by the terms of the IRA document. Generally, the designated beneficiary will be determined as of September 30 of the calendar year following the year of the owner's death.